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Why the Indian Rupee is depreciating and measures to control it

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Why the Indian Rupee is depreciating and measures to control it

There are three questions that needs answer; 1. Why is the Rupee depreciating? 2. What does it means common man? 3. What should be done about it?

Depreciation is used to describe 'a decrease in a currency's value (relative to other major currency benchmarks) due to market forces, not government or central bank policy actions'. In other words, when we say that the rupee is depreciating, it means that if at some time in the past, we could have bought one dollar (or one euro, dirham, pound…) for say 55 rupees, we would now have to pay more. (At last count, this figure had 'breached' the Rs 60 mark), with the change having resulted due to 'market forces' and not government actions.

So what are these market forces and how can they cause depreciation (or appreciation). 'Market forces' are the twin forces of demand and supply, and as economics tells us, if the demand of any good or services is higher relative to its supply, it becomes dearer or costly. Exactly the same holds true for inter-nation currencies as well. Exchange rates are expressed as a comparison of two currencies and it is always relative.

The recent past has seen a number of market events, which have weakened the position of the rupee relative to the dollar and other benchmark currencies. Some of the most prominent among these are:

1. The Euro zone crisis

Sovereign defaults by nations such as Greece, the underperforming international market and increased speculation in the market, has created an atmosphere of doubt and sowed the seeds of negativity in the minds of the investor. As a result, the investors feel it is safer to buy dollars rather than any other assets, this has pushed up the demand for dollars and thus its price; i.e. its value in rupees, has gone up.

2. The rise in current account deficit or CAD

The CAD is the difference between dollar outflow from exports and dollar inflow from imports. A rise in CAD means that we are absorbing more in imports than we are earning from exports, which has led us to paying more dollars than we earn, and thus depleted our foreign exchange reserves. As a result, to pay our import bills, we have to buy dollars, which drives up the demand for dollars and consequently, lowers the value of the Rupee.

3. Economic stimulus measures by US Federal Reserve

Due to the economic slowdown, the US Federal Reserve (the American equivalent of our RBI), has announced a number of measures to 'stimulate' the American economy, which are aimed at ensuring (mostly through lowering of interest rates) that large sums of money is made available to banks for lending to American investors. This has resulted in the strengthening of the dollar and consequently, the weakening of the rupee and other emerging currencies.

What effect does the weakening rupee have on common Indians?

1. Rise in prices

India imports all manner of commodities, the most prominent among these being oil and gold (and weapons, but that doesn't count, of course) to the more nondescript foodgrain. The falling rupee has pushed up the prices of these commodities, which means that 'people like us' will probably have to cut back on spending, postpone the purchases of jewellery, or a new car. For the poor man eking out a living on the street it will mean more misery, more hunger, and more pain.

2. Widening of the Fiscal Deficit

At last count, the fiscal deficit was somewhere near the Rs 5 lakh crore mark. A weakening rupee will further widen this already colossal chasm between the government's revenue and expenditure as the government will have to pay a higher amount (in rupees), to repay its debt (in dollars). India's fiscal deficit is already termed as 'unsustainable' (interestingly, so is America's), and a further rise not only raises serious questions about the government's financial management capabilities but also contributes to rising inflation and damages the state's ability to support growth in case of a slump in industry. This puts thousands of businesses and millions of jobs at risk.

3. Reduction in growth rate

In the present deplorable condition of the rupee, it is fairly obvious that not only are foreign investors collectively scoffing at the idea of earning in rupees, but even Indian businessmen, who are after all, businessmen, are saving their patriotism for cricket and promptly moving their investments overseas. This is affecting the growth rate adversely.

How to control it?

We have already observed that depreciation is caused by market forces, which are global in nature and extremely difficult to control. However, certain measures can and should be taken to arrest this rather drastic fall, some are suggested below:

1. Improving the climate for foreign investors

The most obvious way to offset distribution is to increase growth and bring more dollars into the system, thus reducing the CAD. Relaxing of norms for FII investments is one of the more obvious ways to do it. Providing infrastructure and local support to the investors is another, admittedly more difficult avenue that can be explored in this regard.

2. Making government bonds available to a wider investor base

Making government bonds available to non-resident investors will also increase the inflow of dollars in to the country and help contain the CAD, and in turn, the depreciation of rupee.

3. Measures by RBI to strengthen the rupee

The Reserve Bank, in its capacity as India's central banking institution and monetary policymaker, has, at its disposal a number of instruments with the capability to arrest depreciation. Some examples of such measures are: Deregulation of interest rates on deposits from non-resident Indians, introducing measures to curb speculative trading and sale of dollars from forex reserves.

In today's day and age, when financial networks span continents and financial decisions and measures are made keeping in mind a global outlook, linking nationalism and economics is a colossal mistake. Although some measures are necessary to protect people against the adverse effects of drastic depreciation, drastic measures such as curbing imports should be avoided as they may create more problems than they solve. Nations and governments should realize that depreciation and appreciation are phenomena created by the immense interconnected ecology of the global free market and stick to policies that do the simple thing: create infrastructure and promote inclusive growth.